KMLM: A Decent Bond Alternative

Thesis

KFA Mount Lucas Strategy ETF (NYSEARCA:KMLM), as a hedge fund with an ETF structure, is a well-designed product for those looking to diversify. In my view, it's easily a bond replacer because of its historical inverse correlation to the market and, therefore, it's more attractive diversification quality.

As you'll see in this post, its sophisticated methodology has yielded better returns than its competitors because of its unique offering in the market: a managed futures ETF that excludes equities. That alone makes it worthy of consideration even if it's a relatively young product.

I believe that MKLM's fees are reasonable in the context of the value it seeks to provide. And as you will see for yourself, even a small allocation to it in a traditional 60/40 portfolio could be sufficient in deriving from it a lot more value than what you pay in fees.

Understanding KMLM

KMLM was issued by Krane Funds Advisors on December 2, 2020, and is listed on NYSE Arca under "KMLM". It is co-managed by Krane Funds and Mount Lucas Management.

The fund is focused on trading futures contracts on 11 commodities, 6 currencies, and 5 global fixed-income markets, traded both on U.S. and foreign exchanges. Its goal is to track the performance of the KFA MLM Index as closely as possible, before fees and expenses. Now, a look at the index to fully understand KMLM's methodology is in order.

The KFA MLM Index is a modified version of another one called the "MLM Index", which uses a rules-based methodology. It was created in 1988 for measuring the performance of actively managed futures investments that used a trend-following strategy. Its performance proved to be negatively correlated to equity markets during market-stress periods, such as the financial crisis in 2008 and the COVID crisis in 2020.

Based on the methodology of the index, KMLM receives long or short trend signals on a daily basis which are based on the relationship between every market's price and its long-term moving average. Additionally, it will roll contracts on each market forward as they near expiration and depending on liquidity and market volume for the constituents, the index committee will determine deletions and additions. As for allocation, it weighs the contracts on the three asset classes based on their relative historical volatility and rebalances the portfolio on the first of each month.

Now, to be more specific, the commodity basket KMLM invests in consists of sugar, soybeans, crude oil, copper, heating oil, cattle, wheat, natural gas, gasoline, gold, and corn.

The currency basket consists of the Japanese Yen, British pound, Canadian dollar, Australian dollar, Euro, and Swiss franc.

Last, the fixed-income basket consists of the Long gilt, euro bund, Japanese government bonds, Canadian government bonds, and U.S. Ten-year Treasuries.

Note that the above positions are and will be either long or short depending on the trading signals for each market.

Now, it's important to keep in mind that though KMLM may be using a passive strategy, the issuer states that it may not always replicate the index. According to Mount Lucas, the fund will attempt to maintain its exposure to the same futures as in the index, but it's flexible regarding the maturity dates of the contracts, their weightings, and the rebalancing dates. Another way it may deviate from the benchmark's strategy can be a direct or indirect investment in debt securities and money market funds.

Equipped with an idea of what KMLM does, let us march forward to examine its performance...

Performance

First of all, KMLM's cumulative returns since inception have been 45.90%, as of 02/28/2023. For context, the benchmark's price increased by 55.58% during the same period. In addition, the fund returned an average of 18.33% per year since inception, while the benchmark's price increased by 21.77% per year.

This will naturally cause mixed feelings because these returns are very high on an absolute basis but deviate by a large margin from the price performance of the index. Fortunately, there is an explanation. Mount Lucas justifies the discrepancy in performance by pointing to the fact that KMLM is invested in the Schwab Short-Term US Treasury ETF (SCHO) instead of Treasury Bills, which the index includes instead. According to the issuer, this investment is mostly to blame for the difference in performance.

Now, a comparison with SPY is more useful at showing us how effective this ETF is:

Since its inception, KMLM returned 43.39%, outperforming SPY's much more modest 15.08% gain. Naturally, investors who are looking for an equity hedge will find the fund's inverse correlation to SPY even more appealing than the returns themselves.

On that note, since this ETF worked so well as an equity hedge, what about bonds? A comparison to Vanguard's Total Bond Market ETF (BND) during the same period is in order:

Evidently, KMLM did a much better job as an equity hedge. BND shed 12.4% since KMLM's inception.

Last, there are some similar ETFs that trade futures, so we should also examine their historical returns as well:

While both of the above ETFs have outperformed the market, they underperformed KMLM. DBMF returned 28.39% since KMLM's inception, while FMF returned 10.99%.

We should note that those funds also invest in equities, while KMLM doesn't. That might explain KMLM's outperformance and higher volatility. In any case, KMLM appears superior to these ETFs and should be a better fit in a diversified portfolio.

Fees

Today, the fund has approximately $285 million in assets under management and charges a 0.92% expense ratio. In the context of the small size of capital KMLM currently manages and its methodology, the expense ratio is reasonable.

Comparing its fees to those of competing ETFs confirms this. The iM DBi Managed Futures Strategy ETF (DBMF) charges 0.85% and First Trust Exchange-Traded Fund (FMF) charges 0.96%. The first manages assets almost three times the size of KMLM's AUM and the second manages about $100 million less than KMLM. Considering the fact that KMLM has outperformed both of those funds by a wide enough margin, the expense ratio is fair on a relative basis as well.

All in all, while I understand an expense ratio of 0.92% can make any investor uncomfortable, you must remember this is basically a hedge fund within an ETF; there's unique value in its methodology. Additionally, its assets under management are still small and its track record admirable. Personally, I wouldn't select a less expensive competing ETF.

Risks

Let us now consider the most significant risks when it comes to investing in KMLM:

• Derivatives Risk: Since the fund uses futures to get exposure to various asset classes, the risk associated with derivatives is considerably more pronounced here.
• Commodity Risk: Commodities are a relatively highly volatile asset and a substantial part of KMLM's portfolio.
• Currency Risk: The fund focuses a large part of its portfolio on currencies, which are directly subject to macroeconomic events.
• Fixed-Income Risk: KMLM also invests in fixed-income futures and, therefore, is indirectly exposed to interest rate and credit risk.
• Concentration Risk: In essence, KMLM is an index fund and, for that reason, may concentrate on a particular industry if the index itself does so.

If you are interested in the full list of risks, you can visit this page.

How Does KMLM Fit Into a Portfolio?

Last but not least, we should examine how this fund could be a part of your portfolio.

Since KMLM is unique in that it doesn't invest in equities directly or indirectly, it is designed to appeal to investors with a classic equity/bond allocation. More specifically, it is meant to replace a bond allocation to the extent the investor's judgment will permit.

The issuer believes that allocating 5%-10% to managed futures might be suitable for a 60/40 portfolio. Further, the issuer shows an example in which a traditional 60/40 portfolio with 10% invested in KMLM yielded a higher return, lower volatility, and lower drawdown.

As we observed above, returns for KMLM were far better than BND since the former's inception. It stands to reason that the more you replace your bond allocation with KMLM, the better returns must look.

So, I ran two backtests; one that follows the issuer's example of a 60/30/10 allocation and one with the bond allocation completely replaced by KMLM; both with SPY for the equity allocation and BND for the bond one. The benchmark used for both backtests is a SPY/BND portfolio with a 60/40 allocation. Rebalancing was done every 4 weeks.

For the first backtest, the total return since KMLM's inception was 8.69%, while the benchmark returned 3.57%. That's a substantial difference for such a small allocation to KMLM. In addition, the maximum drawdown was -15.82% for the KMLM portfolio and -20.57% for the benchmark.

Naturally, the second backtest's results are even more interesting. The SPY/KMLM portfolio returned a total of 26.54% and its maximum drawdown was -8.79%.

It's up to every investor to choose how much to allocate to KMLM based on their comfort level. In my opinion, having both KMLM and a bond ETF in a portfolio causes some kind of overlapping; with KMLM, you get exposure to fixed income anyway. The only problem I see is that there's not much freedom in tweaking that exposure; so the only reason to have both a bond ETF and KMLM in your portfolio might be this, in my view.

Verdict

All in all, I view KMLM's offering as attractive for diversifying and its fees reasonable. Its track record is still short but the index the fund tracks is well established. Therefore, I think we have enough evidence that this ETF is a reliable bond alternative.

For those looking for a hedge against equities, KMLM's apparent inverse correlation so far makes it a well-designed product. But it also seems to me that it can be a valuable vehicle to market timing traders as well.

What do you think? Let me know if I missed anything and what your thoughts on this ETF are. I will try to answer every comment.